4.1.8.9 ~ Government Intervention in Markets

• Inelastic specific/unit taxation diagram:

  Steep inelastic demand curve

  
• Elastic specific/unit taxation diagram:

  Shallow elastic demand curve

  
• Ad valorem tax:

  Based off value (%) e.g. VAT
• Specific/unit tax:

  Based on volume e.g. Tax on cigarettes
• Specific/unit taxation diagram:

  • Supply curves are parallel

  
• Ad valorem taxation diagram:

  • Supply curves are diverging

  
• A subsidy usually leads to...

  • An increase in the output sold of a good or service at a lower market price
• What are the advantages of a subsidy?

  • Increase effective demand

  • More consumption of merit goods -> increase in external benefit
• What are the disadvantages of a subsidy?

  • Expensive

  • Paid by consumers through governmental taxation

  • Firms rely on handouts so become over reliant -> decrease efficiency
• Subsidy diagram:

  • Supply curve will expand

  
• What is this diagram?

  • Government under supply > due to finite resources

  
• Advantages of direct provision:

  • Resource allocation improves

  • No price evaluation

  • All social benefits are likely to be considered when allocating resources
• Problem 1: Large fluctuations in price ~

  • Price acts as a signal and an incentive

  • Large fluctuations in price over a very short space of time:

  ~ Oil, gold, corn

  • Rapid changes in price over a short space of time can result in a confusing picture to producers, they cannot use the price mechanism to help guide them as to the level of production and investment in the long run
• Problem 2: Too high a price ~

  • For essential items and merit goods

  • Increases inequalities in society

  • Positive externalities associated with consumption so therefore reduce the price to encourage consumption
• Problem 3: Too low a price ~

  • For demerit goods

  • Negative externalities associated with consumption so therefore raise the price to encourage less consumption of demerit goods
• Maximum price diagram: (1)

  • Free market price is P1 and Q1 is bought and sold. At this price the poorest in society are not able to afford this unit

  • Government intervenes to fix a price of P3 to ensure that all can afford

  
• Maximum price diagram: (2)

  • In the long run, at a price of P2 demand will be higher than at P1, whilst supply will be lower. There will be an excess demand of Q2 to Q3. In theory waiting lists or queues exist. In reality black market may develop where prices are higher than P1. Maximum prices therefore benefit some consumers: those able to obtain the controlled price unit. Those cannot access the unit who would have been prepared to pay P1 now have to pay a price higher than P1

  
• Minimum price diagram:

  • Usually set to help producers increase their revenue therefore the Government decides that the price in a free market is too low for producers to survive i.e. Government set a minimum price of P2 as a result , firms produce more units therefore increased supply into the market resulting in reduced demand. Thus creating an excess supply of Q2 to Q3

  
• Problem of minimum prices:

  • With maximum prices the government did not need to intervene when excess demand occurred

  • Excess supply means that governments do have to intervene

  • Unless the government intervene there will be strong incentives for producers to sell their excess supply below the minimum price

  • Don't want a split market

  • In order for minimum prices to be effective they need to be accompanied by other policies
• Measures of minimum prices:

  • Government buys up the excess supply of Q2-Q3

  • What does the government do with the produce it buys?

  • CAP: wine lakes and butter mountains

  • Sell very cheaply to LEDC's

  • Destroys it

  • Overriding problem is that it is using tax payers money and price paid higher than what they would receive from selling the surplus in a free market
• Restrict supply:

  • Governments can force or pay firms to limit the amount that they produce

  • This involves contracting the supply curve

  • OPEC use this method to manage the price of oil on world markets